Intra-euro area government bond spreads continue to narrow, reflecting expectations of additional ECB measures in December and defying elevated uncertainty vis-à-vis euro area growth prospects
Euro area business leading indicators revealed on Monday further signs of contraction in economic activity. The euro area composite index decreased to a six-month low of 45.1 in November – a tad lower than consensus expectations of 45.5 – from 52 in October (see Economics).
The manufacturing PMI fell by 1.2 pts to a three-month low of 53.6, remaining though above the contraction/expansion threshold of 50 as many businesses remain open and foreign demand (US, Asia) has held well. On a more negative note, the services PMI index declined by 5.6 pts to a six-month low of 41.3 as consumer-driven activity (travel, leisure, hospitality outlets) has been essentially halted in major European economies.
While the hit to economic activity appears less severe compared with the Spring (see graph below) as lockdown measures are less harsh, Europe’s second wave of Covid-19 is still underway and the timeline for the roll-back of containment measures remains unclear. As a result, economic activity is expected to contract in Q4:2020 and early in 2021.
We expect real GDP growth of -3.4% qoq (-7.7% yoy) in Q4:2020 followed by +0.8% qoq (-3.4% yoy) in Q1:2021. The encouraging vaccine developments (Pfizer, Moderna) point to upside growth risks in Q2-Q4:2021. However, caution is warranted until, inter alia, the vaccine is fully rolled out and Europe achieves the desired threshold of herd immunity against Covid-19 (e.g. when the pandemic no longer interrupts economic activity) via massive vaccination. Note that equity markets, as discounting mechanisms, have priced in the positive vaccine news, taking in stride the expected short-term contraction of economic activity.
Indeed, euro area equity momentum continued in the past week with the Eurostoxx index up by +1.4% (+16% MtD ⅼ -4% YtD). Regionally, in the light of positive vaccine news, periphery bourses have overperformed month-to-date (IBEX35: +25%, FTSE/MIB +21%), albeit the performance gap versus the core remains wide at circa 1100 bps year-to-date (see graph below). Valuation expansion has accounted for the majority of the IBEX35 price increase, with the 12-month forward P/E increasing to 21x from 17.8x in late October, whereas 12-month forward EPS revisions is picking up in Italy. Note that financials account for a large share of market cap on both indices (IBEX35:17% and FTSE/MIB 15%, respectively). As a result, both headline periphery indices have found support by the circa 30% rally of the SX7P index month-to-date.
Regarding sovereign bonds, both ECB President Lagarde and Chief Economist Lane, have mentioned that despite positive vaccine news, monetary policy must respond to prevent the short-term (Q4:2020 & early-2021) economic downturn from inducing persistent damage to the economy. We, and consensus, now expect the ECB to extend its pandemic emergency purchase program (PEPP: €1350billion with a usage of €681bn as of November 20th or €76 billion per month since inception) beyond June 2021, increasing at the same time the total envelope of the program.
Expectations for the continuation of ultra-loose monetary policies by the ECB have sent periphery government bond spreads significantly lower in the past month. The BTP/Bund spread has narrowed by 18bps to circa 110bps – its lowest level since April 2016. In a similar vein, the GGB/bund spread has declined by 25bps to circa 125bps – its lowest level since September 2009.